How Price Discrimination is Good for Global Health (Part 1): Professor Patricia Danzon of The Wharton School discusses differential pricing in pharmaceuticals

When NextBillion Health Care launched its market dynamics initiative earlier this year, we did so in full recognition that it is a nuanced, complicated topic. Markets, particularly emerging markets, are not at equilibrium, where supply adjusts to meet needs. This is particularly important in global health, where markets often require manipulation to get medicine in the hands of those who need it.

Our discussion of market dynamics is evolving from one of definitions to more focused debates. Below, in Part 1 of a discussion with NBHC, Patricia Danzon, the Celia Moh Professor at The Wharton School, University of Pennsylvania, explores some of the basic principles involved in differential pricing in the context of pharmaceuticals. (Part 2 of her discussion can be found here. And an opposing view on differential pricing, written by Suerie Moon of Harvard, can be found here and here.)

Kyel Poplin: What is differential pricing as it relates to market dynamics?

Patricia Danzon: Differential pricing could well arise in markets without direct regulatory intervention. It does not require an overarching, cross-national regulatory framework, but it does require that countries generally accept the basic principles. The basic idea of differential pricing has been developed by some academics and some practitioners, as both appropriate and feasible in the context of pharmaceuticals.

The idea is that manufacturers in unregulated markets have incentives to charge different prices in different markets around the world simply because different countries have very different income levels and therefore different abilities to pay. For example, the price levels that consumers can pay in the U.S., being a wealthy country with extensive insurance coverage, are very different from the price levels that consumers in India or Africa can pay, which have lower per capita income and very little insurance coverage for drugs. No manufacturer wants to set prices that customers cannot afford. So it usually makes sense to charge different prices to customers in different markets, based on differences in income and other factors that affect ability or willingness to pay.

Differential pricing for pharmaceuticals is very similar in concept to what in economic theory is called price discrimination. In standard economic theory, when a firm has the ability to differentiate prices across market segments, the firm’s incentive is to charge different prices to different segments, based on the price elasticity of demand in those different market segments, charging higher prices where demand is more inelastic and lower prices where demand is more elastic or price-sensitive.

There is often opposition to differential pricing because it may seem unfair for the same product to have a very different price in different markets – indeed, “price discrimination” sounds intrinsically unfair. But if producers are able to charge different prices to different groups of consumers based on their ability to pay, then more consumers will be able to afford the medicine and utilization of medicines will likely be greater than if all consumers are charged the same price. If utilization increases with differential pricing, overall social welfare increases because lower-income consumers are able to afford medicines when they face prices commensurate with their ability to pay. Increased utilization also means higher overall profitability for manufacturers and therefore greater incentives to invest in R&D. So although “price discrimination” may sound undesirable, if it increases utilization then it can increase consumer welfare overall. The intuition is clear: If manufacturers charge the same price for drugs in poor countries as in wealthier income countries, fewer people in those poor countries will be able to afford the drugs, compared to differential prices that are related to income.

One common objection to differential pricing comes from people in the countries that face higher prices, who tend to conclude that they are subsidizing those who face lower prices. Specifically, the argument that the U.S. is subsidizing other countries is very common. But this misses the point, that manufacturers will tend to engage in differential pricing when it increases utilization. As long as the prices paid by middle- and low-income countries exceed the marginal cost of supplying them, they are contributing to the fixed costs of R&D. Put differently, the revenue that the manufacturer needs to raise from the richer countries to achieve a given total revenue is less under differential pricing, as long as those consumers who are brought into the market by the lower prices are paying more than their marginal cost. If so, consumers paying these lower prices contribute something to covering the joint costs of R&D, even though they pay less than consumers in richer countries. Differential pricing is particularly important for pharmaceuticals because R&D is a much larger component of total cost for drugs than for most other goods. If sales in middle-income and lower-income countries generate some revenue above marginal cost, this increases manufacturers’ total revenue and their incentive to invest in R&D.

KP: What’s the primary argument against differential pricing?

PD: Another common argument – and I believe a misinformed argument – is that the U.S. pays higher prices because some other countries pay less. This is another variant of the notion that the U.S. is subsidizing other countries, and it is incorrect. If manufacturers can charge different prices in different countries, their incentive is to charge the profit-maximizing price in each country, regardless of prices in other countries. In other words, prices in the U.S. reflect market conditions and willingness-to-pay in the U.S., regardless of whether or not other countries are getting the same products at lower prices. Put it another way: Assume, for example, that India or Europe were willing to pay higher prices … that would not bring down prices in the U.S. That would simply mean more revenue to fund R&D.

KP: What are the important factors to consider when implementing a differential pricing scheme?

PD: Most people are willing to accept the basic principle of differential pricing for low-income countries, once they understand that we’re not paying more just because other countries pay less. Where it becomes contentious is: How much less should other moderately wealthy or middle-income countries pay? Most people seem to agree that the poorest countries should pay less than rich countries. But there is real disagreement on the appropriate price differentials between, say, Europe or Canada versus the U.S. Also, how much should middle-income countries like Brazil pay? That’s where it becomes less a debate about whether or not there are price differences, and more about what the absolute price levels and differentials should be. Those questions of practical implementation are more difficult.

The theory of differential pricing implies that differential pricing can raise overall consumer welfare, but this theory does not answer the question of what the absolute price level should be in any country. For example, countries may accept the principle that prices should be differentiated based on per capita income. But let’s say, for example, that average per capita income in Europe is 30 percent lower than in the U.S. Europeans may still resist paying a price 30 percent below the U.S. price because they may believe that the U.S. price level is too high. So even if countries were to agree on what the percentage differentials should be, that still leaves open the question of how high the absolute prices should be. That’s where much of the practical debate is.

There also remains disagreement over whether per capita income is the only factor relevant to appropriate price differences; for example, should burden of disease or insurance coverage be taken into account? In practice, companies often start with setting price in the U.S., which has relatively few regulatory constraints and is an early launch country. Then they consider what discounts they are willing to give to other countries, relative to the U.S. price.

Another very difficult issue is price differentials within countries. In many low- and middle-income countries, such as India or Brazil, there is huge disparity in income between rich and poor. So, if the price in India or Brazil is based on average per capita income, the drug would still be unaffordable to the poor majority. Moreover, the wealthy minority in these countries may be wealthier than many middle-income people in the U.S. who face a higher price. It’s easier to get general agreement on the principle of average differences across countries than on price differences within a particular country that has very big disparities in income. But if people are not covered by insurance, so are paying out-of-pocket for drugs in lower-income countries, a price that is based on the average income will be unaffordable to the majority of the poorer people.